This column continues a discussion we began last week on super gearing arrangements.

Many investors will be encouraged to enter into super gearing because it allows them to purchase property with their super assets. Consequently our discussion will focus on issues that arise with super fund gearing and property. Many of the points raised however could apply to other asset classes.

The advantage of gearing inside the super regime is that you access its tax benefits and potential asset protection and distribution advantages which aren't necessarily available elsewhere.

The types of assets which can be purchased using super gearing include any asset that a super fund can own directly. The family home, any property you or your relatives intend to live in even if the resident will pay your super fund a market rent are automatically excluded. Also excluded are any assets you intend to use in a personal capacity. It's unlikely the bare trust would be able to own any significant shares in your business enterprise.

What about the bare trust? You might see these called a 'warrant trust', 'simple trust' or even 'security trust'. The bare trust's only beneficiary should be the super fund. This means that the bare trust's trustee cannot be the same as the super fund's trustee. (When there is no difference between the trustee of a trust and beneficiary of that trust then you don't have a trust relationship.)

The key to this bare trust is that its governing rules should be very simple. It's vital that under the bare trust's governing rules the super fund's trustee (as the bare trust's sole beneficiary) is able to take immediate possession of the asset at any time they choose. In effect the bare trust's trustee will have no independent role in respect of the trust property.

The super fund's trustee is unlikely to ask for the asset before the loan is repaid because this would result in the super fund breaching other super fund rules but nevertheless the super fund's trustee must have the ability to make this demand.

Some financial institutions are insisting that the bare trust's governing rules only allow the super fund to take full possession of the asset once the loan has been repaid. Vince Scully, Technical Adviser at SMSF Finance Specialists, believes that this type of provision may give rise to capital gains tax when the asset is transferred from the bare trust to the super fund. The transfer may only be CGT exempt if the super fund is "absolutely entitled" to the asset in the bare trust.

Principal of Townsend's Business & Corporate Lawyers, Peter Townsend, says that the timing of when segments of the purchase transaction occur can be important. "In NSW, Victoria Tasmania and the ACT, the contract to purchase the property must be signed before the bare trust is created. However in WA, Queensland and SA this process has to be reversed – you create the bare trust before signing the contract to purchase the property," he said.

If you get this process wrong then ad valorem stamp duty might be payable twice. "If the super fund is based in one State and the property in another then you follow the rules in the State where the property is located not where the super fund is domiciled," said Townsend.

When exchanging the property sale contracts it's important to make sure they are done in the right names otherwise stamp duty problems can arise.

Townsend says he has seen some people use private money to pay the initial deposit not super fund money.

Let's now look at the loan and the lender.

If an investor has sufficient spare capital in their own name, or related entity, then it's possible to loan that money to the super fund. This can be a great way to escape the maximum concessional and non-concessional contribution restrictions.

Most super gearing arrangements which are now being set up involve third party lending. After a slow start most of the banks appear to be offering super gearing loans.

Some banks are demanding that the super fund's members provide a personal guarantee or additional security. Lenders like the guarantee or security because without it they can only protect themselves by selling the asset purchased with the loan.

Chris Batten, Macquarie Group Services Managing Director, has obtained an opinion from Ernst & Young in relation to the super fund member providing "personal property as security and/or a personal guarantee to the Lender in respect of the loan in consideration for the Lender providing additional loan funds and a lower interest rate".

These personal guarantees or security can create major tax problems for the super fund.

A more valuable property may be purchased and the rental income is likely to be more than that expected from a lesser value property. Similarly where a property of greater value is purchased because of the guarantee then the net capital gain may be more than expected from a lesser value property.

Ernst & Young say that both the income and capital from additional security or personal guarantees may not be seen as non-arm's length income. The income tax laws contain a provision which says that if a super fund receives non-arm's length income or capital then penalty tax rates (46.5%) might apply to that income and capital.

This penalty tax would apply even if the super fund were paying a pension when it is meant to have a 0% tax rate on its income and capital gains earned on those assets.

Next week we conclude our discussion on super gearing by looking at how the asset is transferred out of the bare trust and other important tax and stamp duty issues.

Basic structure of super gearing:

A super fund's trustees decide to buy an asset using a non-recourse loan (the super fund's trustee is the borrower)

The asset is purchased using both the borrowed money and a deposit provided by the super fund

The asset is actually purchased by the trustee of a bare trust which has been specifically set up to hold the asset

The super fund must have a beneficial interest in the asset

The lender's rights are limited to the asset acquired and held in the bare trust

The super fund trustee has the right to acquire full legal ownership of the asset whenever they wish but mainly by repaying the loan in one or more capital repayments

If the under the arrangements the superannuation fund's trustee has a right relating to the asset (other than a right to acquire the underlying asset) then the lender's rights lender against the superannuation fund's trustee are limited to rights relating to the asset.

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